Archives

Top Rated

Anglo American

Two weeks back we highlighted BHP Billiton. Last week Anglo American posted their interim results to the end of June and the share price which had been dropping, fell even further on the news.

The financial results of these large diversified miners is a type of barometer of what is happening in the global economy, especially the strength of that still largely unknown quantity, China. This is because Anglo is involved across a number of base metals including iron ore, metallurgical (used for steel making) and thermal coal (used for power generation), copper, nickel, and platinum. It is also involved in diamonds via their stake in De Beers.

The results were worse than analysts had expected and while a company will always try and put a positive spin on its numbers, over time growth in earnings and return on equity are the main factors in driving up the value of the company and hence its price. In the case of Anglo, they highlighted volume growth especially the record production of iron ore, via their majority stake in Kumba Iron Ore but noted that output from its Brazilian iron ore project would be delayed by at least a year. Because prices of commodities have been declining and a company such as Anglo American is essentially a price taker, its operating profit fell a massive 38% to $3,7 billion from a previous $6 billion.
The table below gives a clear indication of the various areas that Anglo is involved in and the decline in operating earnings from the previous 6 months to June 2011 across all product lines, except other.

Table 1: Analysis of Operating Profit

Source: Anglo American

Price relative

There are numerous ways that analysts assess the value of a company. Essentially the price today will be the discounted sum of all expected future earnings, but because investment professionals also need to make relative decisions, one way is to assess the PE relatives. While there is merit in certain companies trading at higher PE’s than others, over time certain relationships can be identified.
For example since 1982 Anglo American’s PE has traded at 90% of the JSE PE. It traded as low as 53% in 2009 and after recovering fell back to 57% but with the poor results, the PE trades at 77% of the market.

Chart 1: PE relative of Anglo American to the FTSE/JSE

Source: I-Net

When comparing the PE ratio to the well-loved SAB Miller, which has been getting more and more expensive, then a larger discrepancy is apparent. The relative PE’s between these two shares reached a low of just 27% - now at 40%.

Chart 2: PE relative of Anglo American to SABMiller

Source: I-Net

The share price hit a high of over R550 four years ago. It fell to a low of R139 in March 2009 at the peak of the financial crisis and while it has recovered to its current R246 it’s been a sideways and rather disappointing investment.

The price certainly looks cheap, and assuming earnings come in at R30 for the full year, the price to earnings ratio comes in just over 8 times. In terms of market capitalisation of shares listed on the JSE, Anglo has slipped to the 4th largest with a market cap of R346 billion after BAT, SAB Miller and Billiton which has a market cap of R520 billion.

It definitely does appear that some of the smarter money is starting to accumulate this share at these lower prices. This is happening while cyclical shares such as Anglo American have disappointed on their earnings and also when global investors favour the more consumer non cyclicals such as SAB Miller. Time will tell which will make the best investment from these levels.

Diversification

We have often written about the benefits of diversification and how proper diversification can both improve the returns as well reduce the risk of portfolios – by risk we mean the risk of permanent capital destruction of your investment. Important characteristics of assets that will provide diversification to portfolios is that they have an uncorrelated return profile, but that they also have the ability to generate a return in their own right.

Ideally we are looking for diversification strategies that will provide the following return profile:

Over the past 22 years this ‘Diversifier’ has given investors the same return as the ALSI, and when equally weighted with the ALSI (rebalanced monthly) has generated significantly better returns with much lower risk (capital drawdown and volatility).

So, what is this ‘Diversifier’?

Seed’s research has shown that an excellent diversifier for local investors (read ALSI / local equity market) can be found in offshore fixed income linked assets. When used wisely, these assets not only reduce the risk of portfolios, but can also enhance returns. The key aspect to consider when including diversified assets / strategies in a portfolio is to completely understand their return drivers. Offshore fixed income linked strategies will have three main return drivers:
• Exchange rate fluctuation
• Income generated from the capital
• Any possible capital gains / losses

Exchange Rate
At Seed we use the purchasing power parity method (as discussed in previous reports) to determine whether the rand is under or over valued versus a range of currencies. To get the best risk/return payoff in this strategy the rand should be over valued (i.e. prone to weakening) relative to the currency that the diversification is taking place in. While the rand has weakened sharply over the past couple of months, it is still slightly strong when compared to a range of other currencies.

Income Generation
The level of income that an asset generates will influence the foreign currency yield that should be expected, where the preference is for high yields. Interest rates are, however, at historical lows around the world and as such one should not expect to generate significant income from an offshore investment that is linked to cash / bond rates.

Capital Variation
The capital variation return driver will typically have a large impact on this kind of strategy’s total return. As capital gains / losses have a large impact on returns one should be mindful of the risks of capital losses and the possibilities of capital gains in such a strategy. With interest rates at historic lows around the world, the risk of capital losses in government bonds is extremely high, and as such we have avoided this asset class.

The Orbis Optimal Funds are extensively used within the Seed Absolute Return Fund to provide diversification to the Fund and improve its risk/return profile. Orbis Optimal’s broad return drivers are the movement in the rand versus the US dollar and euro (we expect the rand to weaken slightly), interest rates in these two regions (negligible), and the ability of Orbis to outperform global equity markets (we expect them to outperform, particularly in down markets).

As the Seed Absolute Return Fund is focused on generating consistent returns in excess of CPI + 4% per annum, having uncorrelated strategies is particularly important for this Fund. We expect that this strategy will provide the biggest boost to performance in times when the local market is down sharply as local market weakness is typically experienced in conjunction with a weakening rand (good for this strategy) and falling global markets (good for Orbis Optimal as all market risk is hedged out and we expect Orbis to outperform in these periods).

The chart below compares the rolling 12 month returns from Orbis Optimal with the ALSI only in periods when the ALSI was negative (i.e. times of local market stress). What is evident is that in most 12 month periods (over 75% of the time) Orbis Optimal was up when the ALSI was down.

As Multi Managers we are constantly on the lookout for mandates that will improve the risk/return profile of our Funds. This involves research on both the types of strategies and the managers’ best suited to manage these strategies. We then need to ensure that we increase the allocation to those strategies that are expected to produce the best returns in the given market environment, and reduce the allocation to those that aren’t experiencing favourable conditions.

The Libor Debacle

Libor stands for London Interbank Offered Rate. This rate is determined daily at 11:00am by Thomson Reuters on behalf of the British Bankers Association by a process of polling leading UK banks and inquiring at what rate that bank could borrow funds from other banks in reasonable market sizes. From the range of rates received the top quarter highest and lowest are thrown out and the remaining rates averaged and fixed daily. The rates for various maturities are published ranging from 1 day to 12 months.

Libor is then used widely as the base reference for many types of derivatives (i.e. agreements between two or more parties referenced back to some underlying prices), such as interest rate swaps, various commercial agreements such as floating rate loans to simple mortgages. It is estimated that the Libor rate is the benchmark reference rate to at least $350 trillion in derivatives and other financial produces (a number as high as $800 trillion was quoted by the Economist) – giving a reflection of just how important this rate is to the global world of finance.

Despite the fact that the rates are collected daily by a polling process and there is a strong argument that these should be based on rates that are actually being paid by one bank to another, the reality is that especially during the global financial crisis the interbank market, where banks lend to one another, was not operating as it should, i.e. banks were not typically lending to one another but preferring to overnight deposits back with central banks. So in times of financial stress even actual numbers can be highly distorted.

It has recently been revealed that since the 2008 financial crisis and possibly before then, regulators have been both aware and in some cases concerned about the actual rate being set and the mechanisms of the Libor process. In June Barclays was fined $456millon by various regulators, including the FSA and the United States Department of Justice after admitting to inaccurately submitting Libor rates from 2005 to 2009.

The chart below from The Economist reflects actual rates submitted by Barclays and JP Morgan relative to the actual fixed Libor over the 2008 period. It gives a reflection of how far these two deviated from the other submitters.

Time magazine cover in July reads, “Barclays is just the beginning. Why London breeds financial scandals –and why this one could be the biggest yet.”

Locally the interbank rate quoted is the Jibar (Johannesburg Interbank Agreed Rate). This rate is quoted as a one, three, six, and twelve month interest rate and like Libor is the basis for various contracts. While the government via the Reserve bank Monetary Policy fixes the repo rate, Jibar is in essence an approximation of what the banks believe the repo should be, but is based on the average interest rate at which banks borrow and lend. Over time the repo rate and 3 month Jibar will move in sync. Where Jibar and Libor differ is that Jibar is based on actual agreed rates, whereas Libor is a submitted (but not verified) rate

Now various global non Libor submitting banks and other large institutions are considering litigation, should they be in a position to prove losses. Ultimately there is an undermining of confidence in the global banking and financial system, which has over the last few years suffered from a rather tarnished reputation.

Picking the Current Winner

Who hasn’t heard the warning “past performance is no indication of future performance” before? But why do we still base our investment choices solely on the past performance of a fund?

We cling on the hope that a winning fund will continue its outperformance. By basing your decision only on the past performance of the fund you run the risk of investing into fund after its outperformance or disinvesting out of a good fund at wrong time.

The graph below illustrates this point. It shows the investment flows of Allan Gray Stable fund. This is overlaid with the previous year’s alpha versus the ALSI, the black line, and the following year’s alpha versus the ALSI, the red line.

Source: Allan Gray

The graph shows how investors chase after past performance. In January 2009 R150m of investments was made into the fund due to 36% outperformance it had the previous year versus the ALSI. The following year the fund underperformed the market by 27%.

On the flip side, if you disinvested from the fund in December 2010, you would have missed the 10% outperformance over the following year.

From the graph you can clearly see how the investment and disinvestments lag the past performance of the fund.

The fund outperformed the markets in 2008, because it was able to protect capital during the credit crisis. It underperformed in 2009 because it wasn’t able to fully capture the market rally due to its low equity holding.

A fund’s investment process is much more important than its past performances. By understanding how the fund is managed you will better know what you should expect from the fund going. You will better understand when to increase your holding or to decrease it.

From the above chart we can see that it is evident that the classic warning “past performance is no indication of future performance” is not just an empty warning.

A Look at Investment Clubs

The majority of most investors’ gains are through investing in shares. Investing directly in the stock market is, however, out of reach for most individual investors as it requires too much capital and is often too complex. Most investors gain access to the stock market through their retirement savings and discretionary savings, typically via unit trusts. One of the ways around this, i.e. to become a ‘direct’ investor, is to become part of an investment club.

What is an investment club you may ask?

An investment club is a form of partnership whereby a number of people (usually between 3 and twelve) get together on a regular basis (usually monthly) and contribute a regular amount. This amount needs to be substantial enough to build up capital on the one hand, but not that large that it places too much strain on the members of the club.

The money is pooled and invested into individual shares based on the views of the members in the club. There are a couple of factors which differentiate the successful investment clubs from the unsuccessful clubs, the first being the meetings. The meetings should be held on a regular basis with a formal agenda. This agenda should include education, a report back from the treasurer, analyzing and deciding on what should be bought, and then analyzing and deciding on what should be sold. Most successful clubs make use of advisors but it is important that the members make the final investment decisions. Members should also draft their own ‘club rules’ up front with regards to how decisions will be made, etc, to avoid nasty arguments down the line.

Part of the monthly contribution should be used as a levy for these meetings and to buy books and courses for the education of the members.

It is vitally important that the members are at a similar level of expertise and they should not rely on a single person to make investment decisions. The most successful clubs are typically those where consensus decisions are made.

Generally speaking more liquid instruments should be used e.g. shares and unit trusts, rather than investing in illiquid assets like physical property. It can become a problem if somebody wants to withdraw from the club and the property market is down and you struggle to sell your holdings for a fair price. Having said that, one of the most successful clubs I have seen has property as their major investment. They used the capital they had built up as deposits on properties that financed the rest of their purchases. This takes investment clubs to a whole new level, because debt is now involved, which brings in further issues such as personal sureties, etc.

For an investment club to be successful the procedures for meetings, aims of the club, contribution levels, and reporting policy need to be formalized and in writing. There can be no expectation gaps, because that is when arguments arise. Matters can get very heated when the members’ capital is at stake. Everybody must know what they are getting into before they make their first investment. If your investment club is successful, it can become a substantial part of your total portfolio.

BHP Billiton Plc – Strength in Diversity

BHP Billiton is one of the world’s largest diversified natural resource companies, and one of the largest companies by market capitalisation listed on the JSE. It is the result of the 2001 merger of the UK-based mining house Billiton and Broken Hill Proprietary (BHP), Australia’s foremost resource company. The two companies’ complementary assets and expertise in different commodities proved to be a successful combination ever since. BHP Billiton is a dual listed company, comprising BHP Billiton Limited with its headquarters in Melbourne and BHP Billiton Plc located in London. BHP Billiton Limited is listed on the Australian Securities Exchange, while BHP Billiton Plc has a premium listing on the London Stock Exchange and a secondary listing on the JSE.

The company has a very strong balance sheet and cash flows, but its true strength lies in its ability to diversify across different geographical regions and a wide range of commodities.

BHP Billiton is a major global player in the mining and production of aluminium, copper, energy coal, iron ore, manganese, metallurgical coal, nickel, silver, and titanium. The company also operates in the petroleum industry, being involved in exploration as well as production of oil and gas.

In terms of geography, the company’s diversification is hard to match. It operates in more than 100 locations on six continents, with most of its mining operations concentrated in Australia, South America, and South Africa.

Interim Results

The company has reported strong growth in revenue in its interim results for the half year ended 31 December 2011, with record high production recorded for iron ore and natural gas. Revenue grew by 9.7% to USD 37.48 billion and underlying EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) increased by 8.3% to USD 18.74 billion. EBITDA is a useful measure for comparing earnings across companies and industries, as it seeks to reduce the effects of financing and accounting decisions on the reported earnings number.

Net operating cash flow increased slightly, up 0.7% to USD 12.28 billion, while attributable profit to the BHP Billiton Group declined by 5.5% to USD 9.94 billion. Profits were impacted negatively by the drop in commodity prices towards the end of 2011, as well as slowing demand from the high growth economies of China and India.

The company managed to increase its interim dividend per share by 19.6% to 55 US cents, continuing a recent trend of increasing dividends paid to shareholders.

The table below illustrates the sources of revenue and EBIT (Earnings Before Interest and Tax) for the half year ended 31 December 2011.

Significant increases in revenue for petroleum, iron ore, and energy coal was partly offset by decreases in revenue for base metals, stainless steel materials, and manganese. These figures illustrate the benefits of diversifying across different sectors, as the company’s revenue stream is not overly exposed to the supply/demand or price cycles of any specific commodity. This should result in enhanced earnings stability over the long term.

Current Valuation

BHP Billiton currently trades on a PE ratio of 7.48 and a Dividend Yield of 3.45%. The forward PE increases to 9.01 as a result of a consensus forecast of a drop in earnings at the release of their financial results for the year ended 30 June 2012.

Billiton currently trades at a PE multiple that is very close to its lows during the global financial crisis of 2008, and the same can be said for most shares in the JSE’s resources sector.

The main factors affecting the fortunes of resource companies going forward remain the European debt crisis and its effect on investor confidence vs. risk aversion, and the question of whether demand for resources in the East will slow down significantly or not.

Considering their stance on these two issues, investors have to first decide when these valuations become attractive enough to warrant an increased exposure to the resources sector, and then select companies within the sector whose fundamentals indicate that they could outperform their rivals over time.

Yale Endowment: 2011

The annual Yale Endowment Report is a must read at Seed, and this year is no different. Each year we attempt to gain insights into why this is one of the best performing institutional portfolios in the world, and see if there are any nuggets of wisdom that we can use in the management of the funds and portfolios that we manage on our clients’ behalf.

In summary, the Yale Endowment is a $19.4bn endowment that currently provides over one third of Yale’s annual revenue, while preserving (and growing) the real purchasing power of the capital base for use by future generations. In many ways high net worth individual and family trust investment plans are similar to endowments, particularly where there is a desire to leave a legacy. In years gone by we have looked at how having a well defined drawdown methodology will not only help extend the capital’s life, but that there are also ways to ensure that the annual changes in the drawdown amount aren’t too volatile.

One aspect in this year’s report that struck me was the endowment’s large allocation to illiquid assets. As at the end of 2011 nearly two thirds of Yale’s endowment was invested into illiquid assets! I then took a look back at how this allocation differs to their endowment in 2001, and also compared to the average educational endowment.

The chart below shows how Yale has increased its allocation to illiquid assets over the past decade, and how the average educational endowment holds even less illiquid assets than Yale did 10 years ago. Illiquid assets are defined as private equity, real estate, and natural resources. Quasi-liquid assets are made up of absolute return strategies (typically hedge fund type investments), while liquid assets are those that trade on public exchanges, i.e. equity and fixed income.

The first key observation is that the Yale Endowment hasn’t done well because it invested into illiquid assets per se. Illiquidity in itself doesn’t generate returns, but good illiquid investments have the ability to generate exceptional performance. Illiquid assets by their very nature are often uncorrelated to more liquid assets (as there isn’t an active market that is overly influenced by the prevailing sentiment) and investors are often rewarded with an illiquidity premium, but these asset classes typically require more in depth due diligence and larger investment minimums.

Another observation is that while their allocation to illiquid assets is high, they still have enough invested in liquid strategies to be used to fund the university’s drawdown requirement. The defined drawdown process results in approximately 5% of the endowment being drawn on an annual basis. With this percentage being fairly static, the investment team is able to maximise their return profile. Too often we see individual investors that require a large percentage of their assets to be readily accessible as they are unsure of their income requirement, and by doing so require a large portion of their assets to be invested in low yielding highly liquid strategies.

With 36% of the endowment in liquid and quasi-liquid strategies, in a worst case scenario (i.e. when the illiquid assets can’t be sold) the endowment will be able to fund approximately 7 years of income requirement before having to start liquidating the illiquid assets. In the normal course of business they will ensure that the level of illiquid assets doesn’t rise above a specific pre-determined maximum weighting.

On a practical level many investors are large shareholders in the businesses that they run. For these clients their illiquid assets are locked up in their shareholding, and for them it is important to build up an asset base outside of the illiquid private equity in order to ensure that they will be able to generate sufficient liquidity should the need arise.

Within Seed’s Funds there are a few relatively illiquid strategies which are able to generate outsized returns for the levels of risk assumed. It is important to balance the enhanced expected returns with sufficient liquidity, because the surest way to destroy capital is being forced to liquidate an illiquid asset.